Up & Down Wall Street: Dr. Doom's Diagnosis -- Barron's

1 Apr 2017 10:00 am

by Randall W. Forsyth

There was a time when markets moved not on the televised utterances of Federal Reserve officials or billionaire money managers, but on a small printed report with the unassuming title "Comments on Credit." That was because it contained the latest insights from Henry Kaufman, Salomon Brothers' chief economist and head of the firm's nonpareil research efforts.

Some readers may not recognize the name of the man or the firm, since they were toddlers (or perhaps not yet born) in Salomon's heyday of the 1970s and '80s. During that time, Kaufman earned the sobriquet of Dr. Doom for his consistently downbeat -- but consistently prescient -- forecasts of inflation and interest rates rising to unprecedented levels well into the double digits. Anyone younger than 35 years old has lived only in a period of disinflation and generally falling interest rates.

So it was enlightening and enjoyable to catch up with Henry via telephone on the occasion of the publication of his latest book, Tectonic Shifts in Financial Markets: People, Policies, and Institutions. At my end, his voice sounded the same as it did when he addressed a New York City hotel ballroom packed with clients and media 3 1/2 decades ago to outline his eagerly anticipated forecast for the coming year. But his weekly "Comments" carried as much clout as his annual predictions did during those days of soaring bond yields and extreme volatility.

He later parted company with Salomon over disagreements about the risky tack the firm had taken and formed his own consultancy. Solly would later be hit by the infamous Treasury auction scandal, after which it was folded into various firms that were melded by Sandy Weill into what ultimately became Citigroup (ticker: C).

Kaufman's book offers a valuable history of how we got to the state we're in, most notably the follies of policy makers and market participants that led to the financial crisis and its aftermath. What stands out, even as the markets' attention has been shifted to Trump administration policies and promises, is that the Federal Reserve has attained an unprecedented prominence -- precisely because of its past policy failures.

The central bank under its previous chairmen, Alan Greenspan and Ben Bernanke, failed to grasp the changes in the structure of finance, Henry argues. Securitization, which allowed subprime (and frequently fraudulent) mortgages to be repackaged into investment-grade securities, was one.

Another was the repeal of the Depression-era Glass-Steagall Act, which drastically increased the concentration of the markets and left a handful of megabanks to dominate Wall Street. That, in turn, reduced the breadth and depth of market makers that provide liquidity, leaving only the Fed as a liquidity provider in times of stress.

The reforms of Dodd-Frank have only exacerbated the concentration of financial power, he notes in the book. The result is a far more fragile financial system than in the past, and one more dependent on the Fed.

That said, Henry writes that the secular lows of long-term interest rates already have been seen, with the 30-year Treasury bond touching 2.1% last July (compared with about 3% as we chatted). But, he emphasizes, a secular rise in interest rates similar to what was seen in the post--World War II era, which took long-term bond yields from 2.5% in the 1950s to a peak of 15.25% in 1981, is unlikely to recur.

Henry could foresee a return to 4% to 5% for the Treasury long bond. That range was last visited in 2011 -- before the collapse in yields following Congress' game of chicken over the federal debt ceiling that threatened default and (ironically) resulted in a flight to quality into U.S. debt. The 5% mark was last touched in August 2007 -- just before the financial crisis that would culminate in Lehman Brothers' collapse a little over a year later.

As for the Fed today, the current economic expansion is "getting on in age," he says, with utilization of labor reaching a ceiling (notwithstanding what he calls the secular problem of the depressed labor force participation rate). That implies a continued rise in the Fed's target for the federal-funds rate, which was lifted last month to 0.75%-1%.

But the frailties of the financial system limit how far the central bank can raise the fed-funds rate, which Henry says will force it to consider new, non-interest-rate tools to meet its objectives. This fragility is already evident in other sectors of the credit markets, and he singles out automobile loans as a key area of weakness (about which more to follow).

Curbs or greater scrutiny on lending practices might be employed. In other words, qualitative, rather than quantitative, restraint could be used. That's because interest rates wouldn't have to rise to historically high levels to cause a financial accident. Recall that the Fed pushed the fed-funds rate to what seemed like a benign 5.25% before fissures in the financial structure appeared ahead of the 2008 crisis.

This is the flip side of Kaufman's key observation of the 1970s -- that interest rates would have to rise far higher than ever before in order to stop inflation. Previous restraints on credit, such as interest-rate caps, had put a brake on the system. Deregulation did away with that.

Now, a frail financial system can't take a rise in interest rates, as in past periods. The lack of a robust roster of market makers results in the system being ever-more dependent on the Fed, he emphasizes.

Which, in turn, makes the central bank more politicized than ever. During the election campaign, President Donald Trump made no bones about not reappointing Janet Yellen as Fed chair when her term expires in early 2018. Presumably also on the way out is Vice Chair Stanley Fischer, who like Yellen was appointed by former President Barack Obama. Among the Fed's board of governors, there will be three vacancies when Daniel Tarullo steps down this week. So, of the seven board members, Trump potentially could name five in the next year.

His nominees are likely to be more "liberal," Henry says, in the sense that they are apt to follow more expansionary policies to accommodate the administration's fiscal plans. That would be the opposite of what the critics -- many of them Trump supporters -- charge, namely that the Fed has done more harm than good by keeping rates too low for too long, thus boosting asset values for the rich and hurting small savers.

His new book ends on the note that "you can't go home again," in the sense that the clock can't be turned back to a simpler time. Ideally, he says, it would be better for smaller firms to specialize in their own niches: Investment banks should stick to investment banking, asset managers to managing assets, rather than having all of those functions under one roof, with inevitable conflicts of interest. That would leave a more interventionist Fed presiding over a small roster of mega-banks that may be turned into quasi-utilities, he concludes.

Henry's great strength has always been to present things as they are, not the way we may want them to be.

AS KAUFMAN ASTUTELY OBSERVED, credit distress is becoming visible in the auto-loan sector, with the asset-backed securities market once again playing the role of enabler, just as it did in the housing debacle last decade.

Over lunch a couple of years ago, a money manager described why it was different this time with auto ABS. Unlike houses, on which foreclosures literally take years, the collateral for auto loans can be retrieved overnight by the repo man and his tow truck. The seized car then could be readily resold and financed by a new loan, because the demand for quality used cars was strong and so were their prices. So auto loan defaults were no problem -- then.

Things have changed. There's a glut of relatively young used cars coming back on the market, now that leases of three-year-old models are up. That's pushing down used-car prices, to the detriment of CarMax (KMX), as described fully in " CarMax Could Stall as Risky Loans Rise."

"After inflating like crazy, the auto-loan bubble has at last gone bust, " MacroMavens' Stephanie Pomboy writes. Lenders provided lengthy deals, seven years and more, to get buyers into pricey sport-utility vehicles and pickups, while keeping the monthly nut affordable. The loans can be securitized into ABS, which investors gobble up in the low-interest-rate world.

"These practices are bearing their inevitable fruit," she continues. Auto inventories are bulging, resulting in stepped-up incentives for new cars, which is driving down used-car prices.

The ripple effects are apt to spread far beyond the manufacturers, as they will have to pare payrolls and hours, resulting in lower spending by their workers, reduced tax revenue, and higher outlays by state and local governments. This, at a time when defaults on credit cards and home-equity loans are at three-year highs, Steph notes.

And it comes just as Greenlight Capital's David Einhorn is cajoling General Motors (GM) to create two classes of stock, one to pay rich dividends to income investors, another for capital gains. (See my recent online column " What's Good for Einhorn Isn't Good for GM or U.S.," March 30.) Moody's and Standard & Poor's criticized the scheme, saying it imperiled GM's credit rating.

As Kaufman explained, the implications of market innovations, such as securitization of auto loans or financial engineering, have been poorly understood. To put it in ancient terms, in the Old Testament, Joseph advised gathering grain in good harvests to prepare for the inevitable drought. Einhorn's plan would squander GM's surplus, rather than save it for tougher times, which auto-loan stresses suggest lie ahead.